Investor favorite Honeywell (HON) has had a healthy run thus far this year, bolstered by continued interest in companies exposed to aerospace and defense, as well as news that activist hedge fund Third Point (headed by Dan Loeb) had built a hefty little stake in the company in order to push for change. With the news that the fund had already begun reducing its stake less than a year after its initial investment, it seems that any activist-driven move to supposedly unlock value (spin-off, larger shareholder returns) seems less and less likely. Given that Honeywell now trades near all-time highs on trailing valuation multiples, are the expectations that have been baked into the company’s share price attainable? Or is this another case of a high-flying large cap that simply is too expensive for its own good?
Business Overview, Company Structure
Honeywell is an industrial technology company, one that (like many other large cap industrials) has been trying to pivot itself more towards high-end, niche product lines that are deep technologically. The story here is the software/hardware blend, where the reality is that many smaller market participants simply do not have the access to capital to provide anything anywhere close to Honeywell’s product suite and diversity of offerings. With competition limited, by and large, the company generates extremely healthy margins. There are downsides, as with any large company, it can be tough to turn the company on a dime in response to market actions, and its high growth days are behind it (at least from a consolidated sales picture).
Honeywell breaks itself down into four reportable segments: Aerospace, Home and Building Technologies (“HBT”), Performance Materials and Technologies (“PMT”), and Safety and Productivity Solutions (“SPS”). Given SPS is such a small facet of the story (<10% of operating profit) and also has no compelling growth story attached to it (3% organic growth guidance from management), I think it’s safe for investors to put that aspect of the business aside in order to keep the thesis simple – don’t lose the forest for the trees. Each and every one of these segments has not seen much growth, on both the revenue side or within margin, over the past several years (once you back out acquisition-driven growth in the HBT segment). At the risk of getting ahead of myself a bit here, it is important to remember why Dan Loeb got involved in the Honeywell story for a reason: stagnancy. That can’t be forgotten when it comes time to try and value this business, or when it comes to looking at segments.
Honeywell and Aerospace are basically synonymous, and I don’t think you can mention Honeywell without digging deep into the aerospace side of the business. This is a core competency for the company, with products made up primarily of electronic solutions (including avionics), engines and power systems, and high-end mechanical components. In many instances, Honeywell has established a near monopoly presence in several product categories, such as cockpit safety system products, where the company has 90% market share. The story is similar within auxiliary power systems. Win rates on bids are high, which is a testament to the payoff of the company’s heavy investment approach; 15% of segment sales re-invested into research and development, well ahead of peers. As Honeywell continues to churn out new products (likely increasing content per aircraft), the hope is to finally spur some growth in the segment, which has stalled (sales down 5.5% since 2014). Commercial aerospace has been stronger than other end markets (both original equipment [“OE”] and aftermarket) over the past several years, with these two end markets making up 49% of the business mix. The bias to aftermarket has helped segment margin, given the lack of pricing concessions that are typically found in OE bids. A weakness has mostly been found in defense sales (nearly wholly domestic), as well as within the transportation systems sales market.
Key drivers in a turnaround here likely fall in some changes in trends. The commercial business will remain solid, although a return to growth will likely necessitate some improvement in the business jet OE space, which has remained weak, particularly internationally. Most in the industry blame weak commodity pricing as a driver, given international wealth (Russia, China, Middle East, South America) is generated on strength here. Obviously, we’ve seen oil pricing improve marginally (down in 2017 however), and iron ore has seen a few pricing spikes that point to some improvement there. A defense turnaround also is key; international has been solid lately, but most of the defense revenue generated by Honeywell is domestic. Recent harsh North Korea rhetoric has bolstered the medium-term case here; if there is one thing the President and Congress agree on, its continued defense spending investment. Honeywell will need to be firing on all cylinders to reach its long-term segment margin target of 25% ( currently 21.1% at mid-point of 2017 guidance); historically Honeywell has seen margin in the 20% range, give or take 100-150bps each way.
Performance Materials and Technologies
Performance Materials and Technologies (“PMT”) develops and manufactures advanced materials, as well as providing process technologies and automation solutions, primarily within chemical, petrochemical, and industrial power generation markets. As the AdvanSix (ASIX) spin-off is now complete, sales mix has shifted drastically towards higher margin technology solutions, accentuated by the acquisition of Elster (smart metering technology in natural gas), and likely will be again given the acquisition of Nextnine, a leading provider of cyber security solutions for industrial sites. There are positives within the materials businesses as well; Solstice has been a big focus for management, which is a global-warming replacement for fluorocarbons.
While the segment has admittedly seen margin improvement since 2014, a lot of this has been mix-related rather than typical hard-fought margin expansion from production efficiencies or operating leverage, going beyond the AdvanSix spin-off impact. Honeywell UOP, a large contributor to segment earnings, has seen its revenues nosedive as a catalyst and absorbent sales to refiners have fallen off a cliff. Process Solutions, the higher margin business, has remained steady. Investors should keep that in mind given guidance of 23.7% segment margin fiscal 2017, which when taken at face value looks amazing given prior segment margin of 17.9% in fiscal 2014. I don’t want to downplay the turnaround here too much; Q2 2017 order rates were up north of 20%, and that followed into Q3 as well (management expects high single digit). Overall, management is quite pleased with the track of the business here, especially relative to other segments.
Home and Building Technologies
Home and Building Technologies is the second-largest segment at Honeywell (trailing Aerospace in both revenue and bottom-line earnings). Within the segment, Honeywell provides hard products and software designed to help both residential and commercial building owners ensure their property is both safe and operating efficiently. Products include controls and displays for controlling HVAC systems (as well as monitoring air quality), lighting, video surveillance, and ventilation, but the products are far-ranging. Chances are, if a customer wants to monitor a specific aspect of a building, Honeywell makes a sensor with the capability.
Margin expansion has been trailing management expectations. Given the scale of the segment, margin expansion here is the low-hanging fruit. While the segment has been growing ahead of market rates, particularly within residential, that ends up being a minor headwind to margin (residential margin trails commercial). Investors looking for an easy scapegoat can blame acquisitions, which likely have eaten up a lot of management time. Honeywell bought Intelligrated in August of 2016 for $1,488M, a supply chain and warehouse automation provider. This followed the acquisition of Xtralis, perimeter security and smoke detection, for $515M. The Elster acquisition ($4,899M purchase) also saw some assets integrated into the HBT segment – so management has definitely been busy on integration.
Going forward, look for SmartEnergy to help aid growth, as well as growing Chinese sales (up 20% in HPT y/y in Q2). There are a lot of margins to pull here, and management has set expectations pretty low (just 30bps of margin expansion this year at the mid-point). Given the segment generates substantial revenue ($11B in guidance this year), every 10bps of margin expansion is good for $110M pre-tax income, all else equal. Every little bit that can be squeezed out here can be immensely accretive to the top line.
Honeywell trades at 13.9x EV/EBITDA on a trailing basis, and 12.9x on a forward basis. Given the company has spent the better part of the last five years trading in the 10.75x range, there is substantial premium built in today. Sure, the shareholder return program has been a solid one, but there are better places to park your money than a company yielding less than 2%, and the company has not been taking out a meaningful amount of the share float via buybacks in recent quarters (616M of net repurchases this year, trailing $1,390M this same time last year). While that sounds high, remember this a company with a $105B market cap; a billion or two in share repurchases is barely accretive to shareholders. While I try not to read into it too much, Honeywell had $9,821M in cash and cash equivalents at the end of Q2; there is plenty of availability if they truly saw value in shares at current levels. Overall, I think the price of safety is too high here. If you’re actively seeking large cap safety, United Technologies (UTX) looks much more compelling. While United Technologies is certainly not devoid of its own problems, I think the valuation difference here is just a touch overdone.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.